Proskauer’s Edward Lister, special regulatory counsel and a member of the Private Equity Transactions and Mergers & Acquisitions Groups, and John Verwey, Regulatory partner and a member of the Firm’s Private Capital industry group, explain the EU and UK insurance regulation impacting insurers’ investment activity, and provide fund sponsors with practical guidance on how they can avoid being subject to onerous contractual obligations.
The new year represents a fresh opportunity for insurers in UK and the EU, who will currently be finalising and implementing their strategic asset allocations for the forthcoming period.
Fund sponsors have an important role in this process, by ensuring that European Insurers’ investments are sufficient to meet their insurance liabilities and provide satisfactory returns.
Unlike other investors, European Insurers are subject to detailed regulatory requirements governing how they calculate their Solvency Capital Requirements (SCR), and the complexion of their investment portfolios. This background context often results in fund sponsors experiencing an increased operational burden when working with European Insurers.
Insurers’ requirements under Solvency II and UK
EU insurers are subject to ‘Solvency II’, which has been in force for a decade. The UK’s domestic regime, Solvency UK, is based upon Solvency II, with tailoring to reflect the domestic insurance market.
Key regulatory requirements from Solvency II / UK are as follows:
(i) SCR requirements
European Insurers are required to hold assets and capital covering their SCR; a capital requirement calibrated to withstand a 1-in-200-year stress event. European Insurers must perform these SCR calculations annually and monitor their SCR ratios on an ongoing basis.
SCR calculations must reflect all quantifiable risks that affect European Insurers’ solvency, including the ‘market risk’ of volatility impacting asset values, which is quantified based upon asset class, credit rating and asset duration (for bonds, loans, securities etc.).
When European Insurers invest in funds, they must identify all material market risk by ‘looking-through’ to the economic substance of the underlying assets. This exercise is iterative and requires European Insurers to consider multiple levels of fund structure.
If European Insurers cannot ‘look-through’ to these underlying assets, SCR may be calculated based on a fund’s target underlying asset allocation. Otherwise, European Insurers must apply a capital charge on their units or shares in the fund, which is generally higher than for other assets (and therefore unattractive).
(ii) Prudent person principle
Additionally, European Insurers must comply with the ‘prudent person principle’ by ensuring that their investments are sufficiently secure, liquid and profitable, and that investments risks can be properly identified, measured, monitored, managed, controlled and reported on to regulators.
Whilst the ‘prudent person principle’ contains specific rules applying to certain assets for example derivatives can only be used to hedge risks, it does not prescribe investment limits. Instead, European Insurers have latitude to determine suitable investment strategies for their respective businesses provided that they are objectively justifiable.
In practice, European Insurers comply with the ‘prudent person principle’ by setting clear investment objectives with defined exposure limits relating to:
· asset concentrations and qualities;
· issuer concentrations;
· geographic areas;
· exposures to non-traded assets; and
· aggregate risk exposure.
Pressure points for fund sponsors
The regulatory requirements above can impact on fund sponsors, as European Insurance investors often require them to perform additional obligations.
Such obligations may include:
· quarterly ‘look-through’ reporting on fund assets, including in underlying fund structures;
· restrictions on assets to which European Insurers do not want exposure for regulatory reasons, such as equities and securitisations. Similarly, European Insurers could restrict certain investments due to reputational considerations, including in arms, oil and gas; and
· compliance with audits performed by the European Insurer or their regulator.
‘Look-through’ reporting requirements are often most burdensome for fund sponsors, depending upon the granularity required by insurance investors. Fund sponsors may also find it challenging to provide the required information if they do not control the underlying funds.
Additionally, fund sponsors may need to implement effective guardrails to avoid inadvertent breaches of restrictions on asset investments.
Practical tips
Fund sponsors should consider the following when working with European Insurers:
· develop clear and comprehensive ‘boilerplate’ provisions covering reporting obligations and restrictions on investments;
· agree reporting templates setting out the scope and detail of required investment information such as using worked examples;
· involve operations and compliance departments to ensure that agreed obligations are achievable in practice;
· regularly monitor compliance with investment restrictions, and ensure appropriate board oversight over investment activity;
· subject burdensome obligations for example reporting obligations to qualifiers such as ‘reasonable endeavours’ or ‘best efforts’ (a higher standard); and
· implement appropriate guardrails to avoid investments in restricted assets (e.g., blockers on investment platforms, and updating investment management policies).
European Insurers remain amongst the most attractive investors for fund sponsors, particularly as their risk appetites evolve into new asset classes and investment relationships become increasingly embedded.
With the right systems and controls in place, overcoming these additional burdens could be worthwhile to achieve long-term and successful relationships with insurance investors.
